The US and European interest rate swap markets experience intense volatility, making it difficult for traders to price in the impact of the Iran war.

Zhitong Finance APP learned that the Iran war has cast a shadow over global inflation and economic growth prospects, which in turn has also affected the direction of interest rates. This uncertainty has intensified volatility in the interest rate swap market, and traders are betting in the market on what major central banks will do next. As the conflict in the Middle East continues, interest rate bets in the United States and Europe have been swinging wildly and changing by the minute.

The interest rate swap market has attracted a great deal of attention and is seen as an important indicator for measuring interest rate expectations. The price trends in the interest rate swap market show dramatic shifts in expectations. Previously, investors expected the Bank of England to cut rates twice this year (25 basis points each time), but now they expect it may raise rates four times. However, trading activity in the interest rate swap market is far more complex than that, because traders are not only making simple directional bets; some traders also hedge against the risk of fluctuations in borrowing costs.

Volatility in the interest rate swap market also has broader significance. Its volatility can ripple through various asset classes, including stocks and bonds, and even affect mortgages and government budgets.

What is the interest rate swap market?

Traders have been trying to predict the path of central bank interest rates. One of the main ways to track these expectations is through interest rate swaps linked to the risk-free overnight borrowing rate—these benchmark rates represent the cost of overnight interbank borrowing and move in sync with central bank policy rates.

These swap transactions are tied to central bank decision dates and involve both parties exchanging streams of interest payments over a specified period. If investors bet that the central bank will raise rates: then they agree to pay a fixed interest rate while receiving a floating interest rate that varies with day-to-day changes in the overnight borrowing rate. If they choose to receive the fixed interest rate while paying the floating rate, then they are betting on rate cuts.

As traders build these positions, the fixed interest rate is adjusted until supply and demand are balanced—in other words, buyers and sellers agree on the level of the central bank interest rate for a specific period.

But this does not mean that such consensus should be treated as gospel. Swap market pricing often fails to accurately reflect the magnitude and speed of actual interest rate changes. For example, based on the measures previously taken by the UK to respond to the pandemic, it is clear that traders did not judge in time how many rate hikes were needed to curb inflation, and then once interest rates stabilized, they overestimated their expectations.

Who is using the swap market?

Banks, asset management companies, hedge funds, and corporates all use the swap market, either to hedge central bank policy risk or to guard against risks arising from future interest rate volatility. For example, if a company holds floating-rate loans, its interest expense will also increase as central bank rates rise. To hedge this risk, the company can enter into a separate interest rate swap contract (typically with a bank), paying a fixed borrowing cost but receiving a floating interest rate in return.

Similarly, investors holding a large amount of bonds may want to hedge the risk of central bank rate increases, because rising rates cause bond prices to fall. If they sign swap contracts to receive the floating interest rate, then when rates rise, they can profit—thereby offsetting the price losses in their bond portfolio.

Hedge funds’ investment horizons are usually much shorter than those of the companies that use swaps for hedging. Therefore, these funds may use the swap market’s volatility to bet on the speed and magnitude of interest rate changes.

Why have interest rate bets in the United States, the UK, and the euro zone been so turbulent recently?

Since the outbreak of the Iran war, some markets have expected rates to be lowered significantly, while other markets have expected rates to be raised multiple times. The main drivers lie in uncertainty: the conflict disrupts Middle Eastern energy and other commodities supply, pushing up prices, which leads central banks to take measures to contain inflation. At the same time, some investors have started to focus on whether the crisis will ultimately cause economic growth to slow and force major central banks to cut rates.

The swap rates in the euro zone and the UK have undergone the most drastic repricing, because these two economies rely heavily on energy imports and are therefore more exposed to sharp swings in oil and gas prices. The European Central Bank and the Bank of England are mainly tasked with maintaining price stability, while the Federal Reserve has the dual mandate of promoting price stability and full employment.

Volatility in interest rate bets is often amplified when traders bet on the wrong direction, forcing them to close positions, which usually results in losses.

Why is the swap market so important?

Fluctuations in interest rate expectations can affect all kinds of assets, because interest rates are the foundation for valuing almost all assets. For stocks, valuation is typically based on the present value of expected future cash flows, with interest rates acting as the discount factor; if the market expects rate hikes, the present value of those future cash flows will fall.

Interest rate expectations also affect the real economy. If the market expects a central bank to raise rates, investors will demand higher bond yields to entice them to sell cash, which increases the cost of government borrowing and debt refinancing. This typically leads to larger budget deficits and may prompt governments to cut spending on public services.

In some countries, swap rates also affect the real estate market. In the UK, fixed-rate mortgages typically keep interest rates unchanged for two to five years, and swap transactions help determine the rates banks offer. Market volatility makes loan pricing difficult. Since the start of the Iran war, swap rates have surged, causing many mortgage lenders to pull products from the UK market and reducing options for homebuyers.

In the United States, mortgage operations work differently: standard 30-year mortgage rates are not tied to swap rates, but are closely linked to the yield on 10-year U.S. Treasury notes.

Generally speaking, volatility in the swap market makes planning harder for households, businesses, and governments. But central banks can also benefit from it. If swap market pricing works effectively, its impact on the real economy can play a part of the role of central banks—for example, tightening or easing monetary policy—thereby reducing the need for central banks to take policy actions.

(责任编辑：王治强 HF013)

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